Advantages and Disadvantages of Leveraged Buyout

What is a leveraged buyout?

A leveraged buyout or LBO is a type of aggressive business practice whereby investors or a
larger corporation utilizes borrowed funds (junk bonds, traditional bank loans, etc.) or debt to
finance its acquisition. Both the assets of the acquiring corporation and acquired company
function as a form of secured collateral in this type of business deal. Often times, a leveraged
buyout does not involve much committed capital, as reflected by the high debt-to-equity ratio
of the total purchase price (an average of 70% debt with 30% equity). In addition, any interest
that accrues during the buyout will be compensated by the future cash flow of the acquired
company. Other terms used synonymously with an LBO are “hostile takeover,” “highly-
leveraged transaction,” and “bootstrap transaction.”

Going private
Once the control of a company is acquired, the firm is then made private for some time with
the intent of going public again. During this “private period,” new owners (the buyout
investors) are able to reorganize a company’s corporate structure with the objective of
making a substantial profitable return. Some comprehensive changes include downsizing
departments through layoffs or completely ridding unnecessary company divisions and
sectors. Buyout investors can also sell the company as a whole or in different parts in order to
achieve a high rate on returns.

The 1980’s buyout boom

Historically, leveraged buyouts soared in the 1980s due to various U.S. economic and
regulatory factors. First, the Reagan administration of the 1980s employed very liberal
federal anti-trust and securities legislation, which greatly endorsed the merger and acquisition
(M&A) of corporations. Second, in 1982, the Supreme Court declared any state law against
takeovers as unconstitutional, further promoting corporate M&A. Third, deregulation
(relaxation, reduction, or complete removal) of many industry-related legislation restrictions
incited further proceedings of corporate reorganization and acquisition. In addition, the use of
risky high-interest bonds (also known as junk bonds) made it possible for multi-million dollar
companies to buyout enterprises with very little capital.

Management buyouts or MBO

The most common buyout agreement is the management buyout or MBO. In this corporate
arrangement, the company’s management teams and/or executives agree to “buyout” or
acquire a large part of the company, subsidiary, or divisions from the existing shareholders.
Due to the fact that this financial compromise requires a considerable amount of capital, the
management team often employs the assistance of venture capitalists to finance this
endeavor. As with traditional leveraged buyouts, the company is made private and corporate
restructuring occurs. Many financial analysts will agree that MBOs will greatly increase
management commitment since they are involved in the high stake of a company.

Pros and cons of leveraged buyouts

Financial analysts strongly believe there are many pros and cons in the leveraged buyout of a
company.

Corporate restructuring
Pros- One positive aspect of leveraged buyouts is the fact that poorly managed firms prior to
their acquisition can undergo valuable corporate reformation when they become private. By
changing their corporate structure (including modifying and replacing executive and
management staff, unnecessary company sectors, and excessive expenditures), a company
can revitalize itself and earn substantial returns.

Cons- Corporate restructuring from leveraged buyouts can greatly impact employees. At
times, this means companies may have to downsize their operations and reduce the number of
paid staff, which results in unemployment for those who will be laid off. In addition,
unemployment after leveraged acquisition of a company can result in negative effects of the
overall community, hindering its economic prosperity and development. Some leveraged
buyouts may not be friendly and can lead to rather hostile takeovers, which goes against the
wishes of the acquired firms’ managers.

An example of a hostile takeover occurred when the PepsiCo acquired the Quaker Oats
Company, an American food company well-known for its breakfast cereals and oatmeal
products. In 2001, PepsiCo, in an attempt to diversify its portfolio in non-carbonated drinks,
primarily acquired Quaker Oats because QO owned the Gatorade brand. Even though this
merger created the fourth-largest consumer goods company in the world, many of Quaker
Oats’ managers were against the acquisition, claiming that such a merger was unlawful and
contrary to the public interest.

Small amount of capital requirements

Pros- Since this type of acquisition involves a high debt-to-equity ratio, large corporations
can easily acquire smaller companies with very little capital. If the acquired company’s
returns are greater than the cost of the debt financing, then all stockholders can benefit from
the financial returns, further increasing the value of a firm.

Cons- However, if the company’s returns are less than the cost of the debt financing, then
corporate bankruptcy can result. In addition, the high-interest rates imposed by leveraged
buyouts may be a challenge for companies whose cash-flow and sale of assets are
insufficient. The result cannot only lead to a company’s bankruptcy but can also result in a
poor line of credit for the buyout investors.

An example of an unsuccessful leveraged buyout is the Federated Department Stores. The

Federated Department Stores had many stores nationwide and tailored primarily to high-end
retailers. However, they lacked an effective marketing strategy. In 1989, Robert Campeau, a
Canadian financier, bought out Federated with the hope to make considerable changes. Only
one year later, and only after some reforms, Federated could not keep up with the financial
burdens of high interest payments and had to file bankruptcy for 258 stores.

Management buyout

Pros- As mentioned earlier, management buyout of a company is a common business

practice. Often times, MBOs occur as a last resort to save an enterprise from permanent
closure or replacement of existing management teams by an outside company. Many analysts
strongly believe management buyouts greatly promote executive and shareholder interests as
well as management loyalty and efficiency.
Cons- Not every MBO turns out to be successful as planned. Management buyouts can
generate substantial conflicts of interest among employees and managers alike. Management
and executive teams can easily be lured to propose a short-term buyout for personal profit. In
addition, they can also corruptly mismanage a company, leading to an enterprise’s
depreciated stock.

An example of a successful management buyout is Springfield Remanufacturing Corporation,

or SRC, an engine remanufacturing plant located in Springfield, Missouri. In 1983, SRC was
at risk for permanent closure and was being bought by an outside company until their
employees decided to buyout the company. The management buyout of SRC resulted in
extreme success. Since 1983, it has grown exponentially from one company within $10,000
of being shut down to a proud assembly of 23 small businesses with a combined profit of
over $120 million today.

Economy

Pros- Every leveraged buyout can be considered risky, especially in reference to the existing
economy. If the existing economy is strong and remains solid, then the leveraged buyout can
greatly improve its chances for success.

Cons- On the other hand, a weak economy is highly indicative of a problematic LBO. During
an economic crisis, money may be difficult to come by and dollar weakness could make
acquiring companies result in poor financial returns. In addition, acquisition can affect
employee morale, increase animosity against the acquiring corporation, and can hinder the
overall growth of a company.

Conclusion

There are many advantages and disadvantages concerning leveraged buyouts. First, this type
of agreement can allow many large companies to acquire smaller-sized enterprises with very
little personal capital. Second, since corporate restructuring can take place, the acquired
company can benefit from necessary reorganization and reform. In addition, management
buyout can prevent a company from being acquired by external sources or from being shut
down completely. However, there are many disadvantages imposed by LBOs as well. Often
times, the restructuring can lead a company to downsize and can even result in hostile
takeovers. The high interest rates from the high debt-to-equity amounts can result in a
corporation’s bankruptcy, especially if the company is not generating substantial returns after
acquisition. Lastly, management buyouts can produce conflicts of interest among employees,
executives, and management teams as well as possible mismanagement by the buyout
owners. With the potential for enormous profit, it is no wonder that leveraged buyout
strategies expanded throughout the 1980s and have recently made a comeback in modern
corporate America.

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